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Massachusetts enacts sales tax on computer and software services

On July 24, 2013, the Massachusetts legislature overrode Governor Deval Patrick’s veto to enact a transportation finance bill (H. 3535) which significantly changes the application of the sales tax to the computer service industry in Massachusetts. Prior to the new legislation, the sale of customized computer software was exempt from Massachusetts sales and use tax. In addition, the only fully taxable service in Massachusetts was the provision of telecommunications services. The legislation expands the definition of taxable services to include “computer system design services” and “the modification, integration, enhancement, installation or configuration of standardized software.” For sales and use tax purposes, “computer system design services” are defined as “the planning, consulting or designing of computer systems that integrate computer hardware, software or communication technologies and are provided by a vendor or third party.” Accordingly, under this broader definition of taxable services, the rendition of computer system design services and the customization of otherwise standardized computer software will now be subject to sales tax in Massachusetts. However, the legislation specifically excludes data access, data processing and information management services from the definition of taxable services.

In a preliminary effort to explain the impact of these statutory changes on the computer service industry, the Massachusetts Department of Revenue issued Technical Information Release No. 13-10 on July 25, 2013 (the “TIR”) (a copy of the TIR can be found here). The TIR makes clear that the expanded language describing the modification and enhancement of standardized software is intended to encompass, and consequently tax, customization services with respect to prewritten or “canned” computer software. However, certain personal or professional services that do not constitute computer system design services or software modification services will not be subject to sales tax under the new law. Examples of exempt professional services include (a) consulting and evaluation services with respect to existing computer systems to identify deficiencies and needs and (b) services to prepare a business to use modified software, including training. The TIR emphasizes that, in order to remain exempt from taxation, these professional services must not be directly related to a particular system integration project involving the sale of computer software or hardware.

In addition, the TIR provides sourcing rules to determine when the sale or use of computer services is taxable in Massachusetts. If a purchaser who intends to use computer services in multiple jurisdictions provides a Multiple Points of Use Certificate (“MPU”) to a vendor, the vendor is relieved from any sales or use tax collection liability. Instead, the purchaser must apportion its use and remit the appropriate amount of use tax. The TIR provides basic apportionment rules for the purchase of software modification services and computer system design services. If a purchaser has not provided an MPU to a vendor, the vendor must collect and remit tax on the sale or use of computer services if the transaction is sourced to Massachusetts under the following rules (to be applied in the order of priority listed):

The sale is sourced to the business location of the vendor if the purchaser receives the services at this location.

The sale is sourced to the location where the services will be received if the purchaser gives the vendor the delivery location.

If the purchaser does not specify the specific location for the services to be delivered, the vendor must source the transaction based on known information (such as the purchaser’s business address or billing address).

If the delivery location and the purchaser’s address cannot be determined, the sale is sourced to the vendor’s address where the sale took place.

If a vendor fails to collect sales tax on the sale of computer services purchased in Massachusetts, the purchaser must remit the properly apportioned use tax.

The new sales and use tax on computer services goes into effect on July 31, 2013. Under transitional rules, otherwise taxable services performed under contracts entered into before July 31, 2013 will not be taxable unless a payment under such contract is invoiced, billed, or due under the terms of the contract on or after July 31, 2013 and the payment relates to services performed on or after July 31, 2013. Moreover, computer service transactions performed on July 31, 2013 are required to be electronically reported and paid together with August 2013 transactions by September 20, 2013. The online forms will be modified to incorporate the new tax. The Department of Revenue also intends to issue further guidance, including an amendment to Regulation 830 CMR 64H.1.3 (Computer Industry Services and Products), regarding the application of the sales and use tax to computer industry services in general.

On July 31, 2013, the Massachusetts Department of Revenue provided additional guidance on the new tax on computer services by publishing responses to a series of frequently asked questions it had received in reaction to the enactment of the tax (the “FAQ”)(a copy of the FAQ can be found here). Frequently Asked Questions: The New Computer and Software Services Tax Effective 7/31/13. At present, the Department of Revenue has responded to forty-four (44) questions. However, as the Department of Revenue receives additional inquiries and more common issues are raised, the advice provided in the FAQ is expected to be updated and supplemented.

Although the FAQ helps clarify several key topics, the breadth of materials discussed in the FAQ highlight the complexities of the new computer services tax. Below are some of the more significant topics examined in the FAQ:

Installation Services. The sale of installation services of prewritten computer software will be subject to the tax in Massachusetts regardless of whether such services are sold in combination with computer system design or the customization of prewritten software or alone.

Custom v. Customized Software. The sale of purely custom software (software not based on other prewritten software) will remain free from taxation. However, the modification of prewritten software for use by a specific purchaser will now be subject to sales and use tax in Massachusetts. Moreover, the licensing of modified prewritten software (“customized software”) will also be subject to tax in Massachusetts.

Website Design. Website design may be subject to the computer services tax depending on the means through which the designer creates the client’s website. If the website designer modifies Open Source code or other prewritten software to satisfy a customer’s requests, the design services will be subject to tax. In contrast, under the principles set forth above, if a website designer creates new custom software to implement the website, the design services will not be subject to tax.

Subcontracting. Massachusetts vendors that subcontract work on a computer system design services project may provide a resale certificate to the subcontractors performing the taxable services that will be resold to the vendor’s ultimate client to avoid the tax on the subcontracted work.

Computer System Design. The taxation of design or consulting services depends on whether the services are provided in conjunction with the sale of hardware or software. For example, no sales or use tax will be due if a vendor designs a computer system that is never actually constructed; the design services did not result in the sale of a computer system that integrated computer hardware, software or other communication technologies. On the other hand, where a vendor designs a new computer system and installs the system on equipment and software purchased by the client from a third party, the transaction will be subject to tax. The purchase of equipment and software from an unrelated third party will not change the fact that the vendor sold computer system design services.

Exemptions. Many of the typical sales and use exemptions apply to sales of taxable computer services. For example, the FAQ explicitly provides that sales and use tax exemptions will apply to (i) sales for resale, (ii) sales to the United States, the Commonwealth or any political subdivision thereof, or their respective agencies, and (iii) sales to 501(c)(3) organizations.

Prepaid hours. Prepaid hours purchased and paid for before July 31, 2013 will not become taxable even if the purchased services are performed on or after July 31, 2013.

Nexus. Out-of-state computer service vendors may rely on previously established nexus principles when determining whether they must collect and remit Massachusetts sales tax. Accordingly, a vendor must have some physical presence in Massachusetts in order to be required register for and collect Massachusetts sales tax on computer services. If the vendor does not have physical presence in Massachusetts, the Massachusetts purchaser will have to self-report and pay use tax on the transaction.

In addition to the above guidance, the Massachusetts Department of Revenue has established a web page devoted to informing taxpayers about recent tax changes in Massachusetts, including the new sales and use tax on computer services (a link to this website can be found here).